How does one go about systematically comparing companies within a given industry? Do you compare P/E ratios? EPS? Sales growth? ROE? PEG ratios? All are conventional metrics that may seem integral to the investment process, when in fact, they all may be mis-leading.
Take the given example of company “A” with a price of $10,000, sales of $12,000, net earnings of $1,000 and sales growing at 10% per annum. While company “B” also has a price of $10,000, the sales are $10,000, with earnings of $900 and sales growing at 10% per annum. Both also have $5,000 equity. At first glance you may think company “B” is priced higher based on the conventional PEG ratio of 1.11 versus 1, the P/E of 11.11 versus 10 and equal sales growth (Ceteris Paribus).
Now you may take the opposite opinion that company “B” is of higher quality due to the net margin percent or how efficiently they convert sales to net income. I would argue that the information is incomplete and we must ask ourselves how much capital was used to produce the sales (working capital) as well as how much capital (capital expenditures) will be needed to sustain the 10% growth in the future.
I would side with both Buffett and Greenblatt on the importance of the working capital profitability ratios (Sales/(Current Assets – Current Liabilities), used in combination with both ROIC and inventory turnover (including fixed assets, says Buffett) when determining companies financial strength in a given industry. Greenblatt does not include goodwill or intangible assets due to the complexity of valuing these assets accurately (brands, patents, excessive purchases, etc.) and uses the following formula:
EBIT / Fixed Assets + Working Capital = Return on Capital
A company's ROIC may be compared to the company's weighted average cost of capital as another source of efficiency. When you calculate the ROIC, working capital profitability ratio and inventory turns within a given industry, it is a great heuristic to take the top ranking company and further analyze the cash flow stream expected in the future, finding an appropriate present value of the cash flows.
The company with the highest ROIC and working capital profitability ratio is likely dominating the industry and will probably continue to do so, as this is clearly a competitive advantage. If you think about it logically, the company is able to turn a higher profit for each dollar invested, enabling them to grow at a faster pace than competition. If the growth rates are essentially the same (like in the example above) the company will use less capital to produce the gains thus leaving a larger surplus for shareholders.
Over time, due to the creative destruction of capitalism, margins will compress (higher costs, lower prices) and the most efficient company will be able to pass their savings to the consumer through further price cuts or simply charging more in relation to costs (higher gross margins) than competitors. The company that is the most efficient will prevail, likely gaining a larger share of the market than it previously had. This is under the assumption of a free market, and the companies in the industry do not participate in a monopoly or duopoly and prices are not regulated or fixed.
Back to our example of company “A” and “B.” You may be asking, "Okay, so ROIC is better than P/Es and PEGs, but why are they fallible and what is wrong with ROE?" Well, simply stated, due to the effect of depreciation, taxes, and other cost cutting, income can be easily manipulated and over-stated/under-stated depending on managements' incentives. In our example, company “A” had $1,000 net income and company “B” had $900, assuming both have equity of $5,000 the ROE of company “A” would be 20% while company “B” would be 18%. Well, it just so happens company “B” has higher deprecation charges (due to a previous acquisition), sheltering some of the taxes with a non-cash accounting entry, had a $100 NOL carry forward and is a royalty-based businesses (uses no or very little additional capex and working capital) to produce its income. Essentially, company “B” had higher net income when we account for the higher depreciation and $100 NOL, as well as a clear competitive advantage, efficiently allocating capital. The choice is an obvious one now… or at least I hope.
Finally (for this post) it is important to understand the elasticity of demand of a particular product or service. Essentially, what are the alternatives and at what price will a consumer make the switch. Take a recent investment of Berkshire in Heinz, a well-known brand of ketchup in almost every house in North America. It is a globally recognized brand and if they decided to raise the price 2% to 5% above their competitors each year, it is unlikely a large exodus would occur. Like they say, “Heinz and no other kinds.” Another great example is toothpaste brand Colgate. When a product is being used in an area as sensitive as my mouth, I want a product I know and trust. I am not going to buy mystery brand “X” to save myself 10 cents on a $2.50 purchase. Colgate could actually raise the price a quarter, maybe even 50 cents and I would continue to pay it, also known as a low elasticity of demand or inelastic. Contrast a pair of socks: I really don’t care what brand I put on my feet and want the absolute cheapest per unit price I can find. Demand is elastic.
In “The Money Masters” there is a small excerpt I would like to end with from John Train provided below:
“When a media executive asked a friend of the Wall Street Journal why it did not tie its ad salesmen’s compensation more closely to their productivity, the friend replied, Well, the salesmen would just go across the street.” The executive answered, “There ain’t no across the street from the Wall Street Journal. These types of businesses make for excellent investments.
Take the given example of company “A” with a price of $10,000, sales of $12,000, net earnings of $1,000 and sales growing at 10% per annum. While company “B” also has a price of $10,000, the sales are $10,000, with earnings of $900 and sales growing at 10% per annum. Both also have $5,000 equity. At first glance you may think company “B” is priced higher based on the conventional PEG ratio of 1.11 versus 1, the P/E of 11.11 versus 10 and equal sales growth (Ceteris Paribus).
Now you may take the opposite opinion that company “B” is of higher quality due to the net margin percent or how efficiently they convert sales to net income. I would argue that the information is incomplete and we must ask ourselves how much capital was used to produce the sales (working capital) as well as how much capital (capital expenditures) will be needed to sustain the 10% growth in the future.
I would side with both Buffett and Greenblatt on the importance of the working capital profitability ratios (Sales/(Current Assets – Current Liabilities), used in combination with both ROIC and inventory turnover (including fixed assets, says Buffett) when determining companies financial strength in a given industry. Greenblatt does not include goodwill or intangible assets due to the complexity of valuing these assets accurately (brands, patents, excessive purchases, etc.) and uses the following formula:
EBIT / Fixed Assets + Working Capital = Return on Capital
A company's ROIC may be compared to the company's weighted average cost of capital as another source of efficiency. When you calculate the ROIC, working capital profitability ratio and inventory turns within a given industry, it is a great heuristic to take the top ranking company and further analyze the cash flow stream expected in the future, finding an appropriate present value of the cash flows.
The company with the highest ROIC and working capital profitability ratio is likely dominating the industry and will probably continue to do so, as this is clearly a competitive advantage. If you think about it logically, the company is able to turn a higher profit for each dollar invested, enabling them to grow at a faster pace than competition. If the growth rates are essentially the same (like in the example above) the company will use less capital to produce the gains thus leaving a larger surplus for shareholders.
Over time, due to the creative destruction of capitalism, margins will compress (higher costs, lower prices) and the most efficient company will be able to pass their savings to the consumer through further price cuts or simply charging more in relation to costs (higher gross margins) than competitors. The company that is the most efficient will prevail, likely gaining a larger share of the market than it previously had. This is under the assumption of a free market, and the companies in the industry do not participate in a monopoly or duopoly and prices are not regulated or fixed.
Back to our example of company “A” and “B.” You may be asking, "Okay, so ROIC is better than P/Es and PEGs, but why are they fallible and what is wrong with ROE?" Well, simply stated, due to the effect of depreciation, taxes, and other cost cutting, income can be easily manipulated and over-stated/under-stated depending on managements' incentives. In our example, company “A” had $1,000 net income and company “B” had $900, assuming both have equity of $5,000 the ROE of company “A” would be 20% while company “B” would be 18%. Well, it just so happens company “B” has higher deprecation charges (due to a previous acquisition), sheltering some of the taxes with a non-cash accounting entry, had a $100 NOL carry forward and is a royalty-based businesses (uses no or very little additional capex and working capital) to produce its income. Essentially, company “B” had higher net income when we account for the higher depreciation and $100 NOL, as well as a clear competitive advantage, efficiently allocating capital. The choice is an obvious one now… or at least I hope.
Finally (for this post) it is important to understand the elasticity of demand of a particular product or service. Essentially, what are the alternatives and at what price will a consumer make the switch. Take a recent investment of Berkshire in Heinz, a well-known brand of ketchup in almost every house in North America. It is a globally recognized brand and if they decided to raise the price 2% to 5% above their competitors each year, it is unlikely a large exodus would occur. Like they say, “Heinz and no other kinds.” Another great example is toothpaste brand Colgate. When a product is being used in an area as sensitive as my mouth, I want a product I know and trust. I am not going to buy mystery brand “X” to save myself 10 cents on a $2.50 purchase. Colgate could actually raise the price a quarter, maybe even 50 cents and I would continue to pay it, also known as a low elasticity of demand or inelastic. Contrast a pair of socks: I really don’t care what brand I put on my feet and want the absolute cheapest per unit price I can find. Demand is elastic.
In “The Money Masters” there is a small excerpt I would like to end with from John Train provided below:
“When a media executive asked a friend of the Wall Street Journal why it did not tie its ad salesmen’s compensation more closely to their productivity, the friend replied, Well, the salesmen would just go across the street.” The executive answered, “There ain’t no across the street from the Wall Street Journal. These types of businesses make for excellent investments.
